What is Mistake "Using too much Leverage" in Trading?

﻿

Among the general public futures trading is generally considered to be a wildly speculative activity. Most people have little trepidation about moving money into stocks or bonds or mutual funds. But ask them if they have considered trading futures and they get this incredulous look on their face and say "whoa, what do you think I am, crazy?"

What is it about futures trading that has earned it such a disreputable reputation? The common perception among the general public seems to be that the individual markets themselves - whether it be Silver, Soybeans or Natural Gas - are wildly volatile and that volatility is what causes most traders to lose money. While there is no question that futures markets can be volatile at times, the markets themselves are not nearly as volatile as many people think, and it is not the volatili-ty of the markets that causes the majority of problems. What causes most of the problems is the amount of leverage used when trading futures. This fact is not widely recognized, however. Before illustrating this let's consider what causes futures prices to rise or fall.

The price of a stock tends to rise or fall based upon the company's earnings per share, or more accurately, on the public perception of that company's earnings outlook. Conversely, the price of a physical commodity moves based upon supply and demand for that product, or more accurately, the perceived supply and demand for that product. For example, if there were a terrible drought in the Midwest the general perception would likely be that growing conditions are bad and that farmers will not be able to grow as many Soybeans as usual. Thus, based on perceptions of lower supply, the price of Soybean futures could be expected to rise. Likewise if growing conditions were perfect and supply was expected to be great, Soybean prices would likely fall. Now let's consider the volatility of the markets themselves.

The first thing to understand is that there is nothing about a bushel of Soybeans or an ounce of Gold that make them inherently more volatile or more risky than a share of stock in IBM or any other tradeable security. In fact, in terms of raw volatility (i.e., the average annual price movement as a percentage of current price), commodity prices tend to fluctuate less than stock prices. Figure 2-1 shows the historical volatility of a group of stocks and futures markets. While this is admittedly a very small sample, note that the average volatility for the stocks in this list is greater than the average volatility for the futures markets in the list. So what's going on here? Does the investing public have it backwards? Are futures really less volatile, and by extension less risky than stocks? Well, not exactly.